While most people know that the interest rate on a loan indicates the price of borrowing money many people remain in the dark when it comes to the ins and outs of interest rates. When terms like AER and APR are brought into play it isn’t surprising that many people start to get confused. This beginners guide from  helps you to find out a;; the basics about interest rates so you can be more informed the next time you apply for a loan.

Interest Rates On Borrowing

If you’re borrowing a sum of money at an interest rate of 5% pa that means that you will need to pay an extra 5% of the total amount that you borrowed on top of the original sum you borrowed. If we take a simple example we can see how this works:

If you borrow £1000 and the interest rate is 10% per year and you repay it after 12 months you will pay back roughly £1100. If you pay it back in 6 months you will pay back roughly £1050.

This looks quite simple, however note the word “roughly”. That’s because compound interest comes into play. However, if you’re looking for a quick frame of reference for how much you need to pay back overall across the life of your loan, this is the easiest way to work it out.

Compound Interest

When you borrow money you don’t just pay interest on the amount you borrowed in the first place, you also pay interest on interest that has already accrued. This is where it starts to get complicated. This isn’t usually a huge problem if you’re only borrowing over a short term however if you’re borrowing for a longer period the faster your debt will mount up.

Let’s look at an example:

If you borrow £1000 at an interest rate of 15% over a 20 year period and make no repayments the amount you owe will end up being £16,400 due to compound interest (rather than just £4000 without it).

Working out compound interest roughly will help you to determine the overall value of your repayments and you can do this by dividing 72 by your loan’s annual rate of interest and the answer will tell you how long it will take for your debt to double.

APR – And Explanation

One of the commonly seen terms when arranging a loan is APR – or Annual Percentage Rate. This rate is calculated to include not only the cost of borrowing but also any fees which have been included. The APR is used to compare the various loan offers on the market and all lenders must let borrowers know their APR rates before any agreement is signed since they vary between providers. Although it can be confusing, it’s gives a more useful comparison tool since all lenders charge different fees and this standardises the system allowing you to see at a glance the value you’re getting.

Unfortuately, in practice, since rates change regularly, the APR often makes no sense. An APR is worked out by taking the entire cost of interest over the period of the loan plus any fees charged. However, even if the loan has an APR of 6.6%, for example, you might never get charged that rate if you are on a fixed rate deal or variable deal. The APR quoted will only represent the average loan cost which may not be very useful in the long term.

To confuse matters further, the APR which is advertised by the provider may not be the APR you receive. Only around half of successful loan applicants receive that advertised rate with others being offered a higher one depending on their credit score and financial circumstances.

The Flat Interest Rate Loan

Although APRs might be confusing, there is a worse form of measurement out there often used by car dealers to try to make their car financing offers sound more affordable. While the flat interest loan is less commonly seen these days, it can still be found so keep an eye out for it.

When shopping around for a car loan or personal loan check to make sure the letters APR follow the quote. APR means that the interest rate will be charged on outstanding debts so, for example, if you borrow a total of £5000 over a five year period with an interest rate of 6% APR, and by the final year of your loan you only have £1000 outstanding, the interest you pay will only be on that outstanding amount i.e. £1000 which amounts to £800 in total at a 6% APR.

In the case of flat rate interest, the interest will be charged on the entire original amount of money that you borrowed regardless of how much you’ve repaid. That means that even in the very last year of repayments when you only have £1000 left outstanding you will still be paying interest on all £5000 you originally borrowed. At a flat rate of 6%, you’ll be being a total of £1500 interest rather than £800 – almost double the amount.

While an interest rate of 6% might sound cheap, at a flat rate of interest it actually roughly equates to an APR of 12% – significantly higher. That means checking credit agreements thoroughly before signing on the dotted line is essential to make sure you understand the terms on which you’re borrowing. As it is illegal to omit the APR from a consumer credit agreement if you don’t see those three letters on your paperwork it means you’re paying interest at a flat rate and you might want to think again.

Although interest rates can be confusing, a lot of the problems that people encounter when trying to work out the amount that they will need to repay on their borrowing comes from the jargon used. This basic beginners guide should help your to navigate through the difficulties of arranging a loan so you get good value for money.

Categories: Finance